 Capital Budgeting and Risk Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 9 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 9- 2 Topics Covered  Measuring Betas  Capital Structure and COC  Discount Rates for Intl. Projects  Estimating Discount Rates  Risk and DCF

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 9- 3 Company Cost of Capital  A firm’s value can be stated as the sum of the value of its various assets.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 9- 4 Company Cost of Capital  A company’s cost of capital can be compared to the CAPM required return. Required return Project Beta 1.26 Company Cost of Capital SML

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 9- 5 Measuring Betas  The SML shows the relationship between return and risk.  CAPM uses Beta as a proxy for risk.  Beta is the slope of the SML, using CAPM terminology.  Other methods can be employed to determine the slope of the SML and thus Beta.  Regression analysis can be used to find Beta.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 9- 6 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 78 - Dec 82 Market return (%) Hewlett-Packard return (%) R 2 =.53 B = 1.35

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 9- 7 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 83 - Dec 87 Market return (%) Hewlett-Packard return (%) R 2 =.49 B = 1.33

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 9- 8 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 88 - Dec 92 Market return (%) Hewlett-Packard return (%) R 2 =.45 B = 1.70

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 9- 9 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 93 - Dec 97 Market return (%) Hewlett-Packard return (%) R 2 =.35 B = 1.69

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 78 - Dec 82 Market return (%) A T & T (%) R 2 =.28 B = 0.21

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 83 - Dec 87 Market return (%) R 2 =.23 B = 0.64 A T & T (%)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 88 - Dec 92 Market return (%) R 2 =.28 B = 0.90 A T & T (%)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 93 - Dec 97 Market return (%) R 2 =..17 B =.90 A T & T (%)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Beta Stability % IN SAME % WITHIN ONE RISK CLASS 5 CLASS 5 CLASS YEARS LATER YEARS LATER 10 (High betas) (Low betas) Source: Sharpe and Cooper (1972)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Budgeting & Risk Modify CAPM (account for proper risk) Use COC unique to project, rather than Company COC Take into account Capital Structure

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Company Cost of Capital simple approach  Company Cost of Capital (COC) is based on the average beta of the assets.  The average Beta of the assets is based on the % of funds in each asset.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Company Cost of Capital simple approach Company Cost of Capital (COC) is based on the average beta of the assets. The average Beta of the assets is based on the % of funds in each asset. Example 1/3 New Ventures B=2.0 1/3 Expand existing business B=1.3 1/3 Plant efficiency B=0.6 AVG B of assets = 1.3

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Structure - the mix of debt & equity within a company Expand CAPM to include CS R = r f + B ( r m - r f ) becomes R equity = r f + B ( r m - r f ) Capital Structure

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Structure & COC COC = r portfolio = r assets

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Structure & COC COC = r portfolio = r assets r assets = WACC = r debt (D) + r equity (E) (V) (V)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Structure & COC COC = r portfolio = r assets r assets = WACC = r debt (D) + r equity (E) (V) (V) B assets = B debt (D) + B equity (E) (V) (V)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Structure & COC COC = r portfolio = r assets r assets = WACC = r debt (D) + r equity (E) (V) (V) B assets = B debt (D) + B equity (E) (V) (V) r equity = r f + B equity ( r m - r f )

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Structure & COC COC = r portfolio = r assets r assets = WACC = r debt (D) + r equity (E) (V) (V) B assets = B debt (D) + B equity (E) (V) (V) r equity = r f + B equity ( r m - r f ) IMPORTANT E, D, and V are all market values

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Capital Structure & COC Expected return (%) B debt B assets B equity R rdebt =8 R assets =12.2 R equity =15 Expected Returns and Betas prior to refinancing

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Pinnacle West Corp. R equity = r f + B ( r m - r f ) = (.08) =.0858 or 8.6% R debt = YTM on bonds = 6.9 %

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Pinnacle West Corp.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Pinnacle West Corp.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill International Risk Source: The Brattle Group, Inc.  Ratio - Ratio of standard deviations, country index vs. S&P composite index

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Unbiased Forecast  Given three outcomes and their related probabilities and cash flows we can determine an unbiased forecast of cash flows.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Asset Betas Cash flow = revenue - fixed cost - variable cost PV(asset) = PV(revenue) - PV(fixed cost) - PV(variable cost) or PV(revenue) = PV(fixed cost) + PV(variable cost) + PV(asset)

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Asset Betas

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Asset Betas

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project? Now assume that the cash flows change, but are RISK FREE. What is the new PV?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV? Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV? The difference between the 100 and the certainty equivalent (94.6) is 5.4%…this % can be considered the annual premium on a risky cash flow

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of.75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Risk,DCF and CEQ  The prior example leads to a generic certainty equivalent formula.